US. Boston Beer Company — A Small Brewer Buffett Would Love

Boston Beer Company (BBC) known primarily through its flagship brand, Samuel Adams, is a simple to understand, highly profitable, and value-creating business with a trustworthy and capable management team. They are the largest and most successful of the small craft brewers, have a growing moat, generate plenty of free cash flow, and have no debt. They currently trade at a small premium to fair value, which I estimate at $83. Buy under $62, with a margin of safety, and keep this one tucked away for the long haul since they have a long road ahead of them to grow.

ANALYSIS OF BUSINESS COMPANY OVERVIEW Primarily through its flagship brand, Samuel Adams, BBC is the largest domestic craft brewer, and the fourth-largest brewer in the United States . Sam Adams competes at the premium end of the beer market with imports and domestic craft and specialty brews, such as Heineken, Corona, Sierra Nevada, Red Hook, Yeungling, etc. The company also markets flavored malt beverages and hard ciders under the brands Twisted Tea and Hardcore Cider. The U.S. accounted for 99% of BBC's volume in 2009, which totaled 2.2M barrels (bbls), giving them a 21.5% share of the craft market for the year. As of the most recently available quarterly filing, shipment volume increased 13% to 616K bbls for the quarter ending September 2010. Although the annual report isn't available yet, BBC expects shipments and orders-in-hand to be up 12% for 2010 compared to 2009. Fiscal year 2011 looks promising as well with double-digit sales. In the US , the liquor industry is a 3-tier structure by law: producer, wholesaler, and retailer. BBC distributes locally through a network of 400 wholesalers and 265 sales people, who then sell to retailers such as pubs, restaurants, grocery chains, package stores, stadiums, and other retail outlets. They also distribute in Canada, Europe, Israel, the Caribbean, the Pacific Rim and Mexico. BBC has almost no exclusive selling contracts or primary brand status with distributors, and must compete with other brewers for time and selling efforts. However, the higher margin potential of their premium products, the increased national marketing focus, the diversity of its products, its top-three "better beer" ranking and leading craft beer status make the brand very attractive to wholesalers. The Samuel Adams brand has growing mind-share in the public and is becoming part of the language…go to a bar and just say "give me a Sam" to see what I mean. Historically, BBC brewed using a combination of organic and contracted facilities. In 2007 and 2008, they took steps to better control brewing on concerns about future availability and pricing as 33% of their production was produced under contract. Their initial plans called for constructing a facility at an estimated cost of $170M-$210M, but instead decided to purchase Diageo's Pennsylvania brewery for $55M—a completely cash transaction. The sale closed in June 2008 and the brewery is in full operation which now gives them the ability to produce 100% of their product. Other company-owned breweries are located in Cincinnati, OH, and Boston, MA . During 2009, BBC brewed certain products under contract at facilities in Rochester, NY and La Crosse, WI . BBC also has contracts to brew certain products in Eden, NC, and Latrobe, PA , which weren't activated during 2009. BBC remains under-penetrated in the Western states. The company began in 1984 with a generations-old family recipe that Jim Koch, Founder and Brewer, discovered in his father's attic. After home brewing the recipe in his kitchen and reviving it, Jim brought it to bars in Boston with the belief that drinkers would appreciate a complex, full-flavored beer, brewed fresh in the US—he was right. This first beer was Samuel Adams Boston Lager which helped catalyze what later became known as the American Craft Beer Revolution. BBC went public in 1995. Today BBC brews over 21 styles of beer, using traditional brewing processes, the world's finest ingredients, and often taking extra steps, like dry-hopping and krausening, to differentiate their beers. They passionately pursue the development of new styles as well as the perfection of classic beer styles. They have earned a reputation as a pioneer in another beer revolution, the "extreme beer" movement, where they seek to challenge perceptions of what beer can be. They elevate the image of American craft beer by entering festivals and competitions across the globe. In the past five years, they've won more awards in international beer competitions than any other brewery in the world. Brewing quality beer is their singular focus. They've also teamed up with other acclaimed breweries to work on brewing projects. One such example is their collaborative effort with the world's oldest brewery, the Weihenstephan Institute in Germany . This project, two years in the making, recently released this past November a new beer called Infinium. While they're the largest craft brewer, they account for 0.9% of the total US beer market. By way of comparison, the three largest brewers maintain an 80% market share collectively. However, their main competition is other craft brewers, where they maintain a 24% market share in the craft beer space.

INDUSTRY ECONOMICS The brewing industry has favorable economics, owing in part to its process. Quite simply, a traditional four-vessel brewery would include a hot liquor tank, mash tun, boil kettle, and fermenter. The first three vessels are used to cook and extract malt sugars from the grains. Afterwards this liquid malt extract, called wort, is placed into the fermenter with yeast where it turns into beer. Once fermented, this new beer will go through an aging process before being packaged into kegs, bottles, or cans. Brewing equipment is bulky and capital intensive up front. It is typically made of stainless steel and is a long-lived asset. Once it's in place, though, it requires little in the way of maintenance capex. Additional brewing capacity is achieved by augmenting existing fermenter capacity rather than wholesale replacement. Fermenters are the chokepoint for any brewery, as inventory must stay in them during the entire fermenting/aging process. If a brewery wants to continue making beer, they must have a multiple fermenter brewhouse. Technology in brewing equipment is a productivity enhancer and rarely are there technological disruptions obliterating a product (think of the buggy whip as an example). The brewing process has remained essentially unchanged for the last 5,000 years, notwithstanding refinements along the way to speed the process or make it easier. Input ingredients (barley, wheat, hops, water, yeast, corn, rice, etc.) are typically inexpensive and lead to high gross margins. Beer has been around since the dawn of civilization, and beer will continue to look and smell like beer into the foreseeable future. Therefore, there's no product obsolescence risk at all. However, shifting consumer tastes could trend towards wine and spirits. For a sense of scale, the overall US beer market in 2009 was $100B, selling over 205M bbls of beer. In comparison, craft brewing represented 9.1M bbls in the US, or a 4.5% market share. However, craft brewing is a fast growing sector. BBC maintains a 24% market share in the craft beer space, is #1 in craft beer sales volume, and #5 in overall US sales. Craft brewers provide approximately 100K jobs in the US . The growth of the craft brewing industry in the first half of 2010 was 9% by volume and 12% by sales. In contrast, US beer sales were down an estimated 2.7% by volume during the same period. The craft brewing industry grew 7.2% by volume in 2009 and 10% by dollars compared to 2008. Overall, US beer sales were down 2.2% in 2009 while import beer sales were down 9.8% in 2009. The number of breweries in the US continues to climb each year with over 1600 currently operating in the US. Demographically, there's been a shift in consumer preference over the last 25 years for niche and premium offerings in the Better Beer category. Consumers also want to customize and personalize their products. There was a time when there was no choice—you could only select from 3 types of beer. But today consumers can pick their favorite beer style, similar to the way consumers can customize their coffee at Starbucks, or personalize their iPod and iPhone. Consumers want choice and BBC brews innovative and unique beers, some seasonal, that have struck the right chord with American beer drinkers. A whole generation of beer drinkers grew up expecting choice and flavor, and BBC is there to provide it. For more information about the beer industry, follow this link: http://www.brewersassociation.org/pages/business-tools/craft-brewing-statistics/facts For more historical context, here's some other information: http://www.breweryage.com/stats/Stats%203-06.pdf http://www.breweryage.com/industry/sales.html

BUSINESS FUNDAMENTALS A qualitative review of the company's financial statements will quickly illustrate the stability of its sales, pre-tax profit, earnings metrics, and returns on equity and capital. This analysis also reveals BBC has either an outright moat, or a moat-in-the-making. This section of the analysis provides a high-level tour of the important metrics prior to considering a valuation on BBC.

THE $1 PREMISE In Warren Buffett's 1983 Owner's Manual for Berkshire shareholders, he stated: "We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained. To date, this test has been met. We will continue to apply it on a five-year rolling basis. As our net worth grows, it is more difficult to use retained earnings wisely." In other words, earnings retention must, in the long run, deliver at least $1 of market value for every $1 retained in the business. It's a simple and easy acid test of whether a company is value-creative, or value-destructive. If the latter, there's no point in continuing the analysis. I prefer looking over a 10-year stretch to span about two business cycles. BBC's market value from 2000 to the current TTM, have increased from $147M to $1285M. Their equity increased from $73.7M to $167.7M over the same period. In short, BBC has created significant value for their shareholders--$12 in market value for every $1 retained. (Note: as a comparison in a different industry, Ford lost $1.07 for every $1 retained—they, and the auto industry, are very value-destructive.)

CAPITAL STRUCTURE BBC is capitalized with no bonds, no preferred stock, no debt (they have access to a $50M line of credit, but have never used it), and 13.6M shares of common stock. Those shares are divided into two classes, A & B. Class A common stock is publicly traded and has no voting rights, except as required by law. Class B common stock is not publicly traded and has full voting rights. Each share of Class B stock is freely convertible into one share of Class A stock. Although not the CEO, Jim Koch, Founder and chairman, has considerable influence over the running of the company. Koch owns around 32% of the firm's stock, including all of the Class B shares, and is able to elect five directors to a board of just eight members. There's a small risk that the interests of minority shareholders will take second place to those of Koch. However, I feel this places Jim in a position of having significant "skin in the game." He's passionate about the company, and has been so since 1984—which, quite frankly, translates to the bottom line. In the last number of years, all of the Big Three breweries were merged with foreign companies. I don't see BBC being acquired at any time, primarily due to this control arrangement, which I believe is good for shareholders overall. The craft beer movement has been around for decades with Jim Koch as one of the leaders. An acquiring company would have negative press, I believe, as it would be similar to the Pillsbury bid to buy Ben & Jerry's ice cream in the 1980s. Ben & Jerry's launched a successful media blitz to put this deal on ice where Pillsbury was viewed as the big, evil conglomerate intent on destroying the small guy. Recent executive compensation has appeared reasonable, and the board of directors boasts a solid range of experience in the consumer products industry.

SALES, PRE-TAX PROFIT, AND EARNINGS BBC has enjoyed low single digit to mid-teens revenue growth in recent years, driven by volume growth and strong pricing. Revenue growth has averaged 14.2% and 14.7% (10yr and 5 yr, respectively). Sales in the latest quarter were $124.5M, compared to $108.7M for the year ago quarter—a 14.5% change. Additionally, BBC has been able to pass along cost increases to the consumer, even during the recession, without long-term detrimental change in demand. The accounting EPS has grown 14% ann. from $0.62 to $3.17 over the last 10 years. Book value growth has followed suit—expanding 14% ann. from $4.41 to $12.53 per share over the same period. As far as margins, gross margins have held steady at around 59% in recent years, but fell to 46% in 2008 on a glass bottle recall, inefficiencies at its new brewery, and a world-wide hop shortage. Gross margins are on the rise again, currently sitting at 54% for the TTM, and should recover to their original values and beyond as efficiencies are realized at the new brewery. They expect 2011 gross margins to be 54%-56%. The 10-year average is 58%. Likewise, their operating and net margins are on the rise again after the brewery investment. Operating margin currently sits at 13%, while net margin is over 7%. A graph of the pre-tax profit curve versus revenues illustrates the margins story. Since 2000 they've continually narrowed the gap in an environment of stable tax rates and net cost reductions from operations.

COST STRUCTURE As a percentage of sales, COGS for BBC has normally stayed stable in the low 40%-43% range. However, it peaked to 53.8% during 2008, as a result of the brewery expansion. Since then, it has started to trend downwards and currently sits at 46%. I fully expect BBC to return to its normal COGS standards, an average of 41% for the last decade. SG&A, as a percentage of sales, has averaged 46% for the last decade, and is currently on a downward trend at 37%. It has grown approximately 7% during this period, considerably less than their sales growth which is due primarily to core shipment volume increasing at a higher rate than increases in SG&A. BBC has no R&D expenses. Isn't brewing great?

OWNER EARNINGS, ROE & CROIC In his 1986 letter to shareholders, Warren Buffett described the concept of 'owner earnings'—the cash that a business can generate for its owners. He stated, "…we consider the owner earnings figure, not [net income or earnings], to be the relevant item for valuation purposes—both for investors in buying stocks and for managers in buying entire businesses." Owner earnings are calculated as: Owner Earnings = Net Income + Depreciation & Amortization + Non-cash charges – Average Capex Up until 2008, BBC owned 2 breweries. Maintenance and growth capex from 2000-2007 tells us that average capex per brewery ran anywhere between $5.8M (excluding 2007) to $8.3M (including 2007), which gives us a suitable basis to estimate total capex for 3 breweries post-2008. This figure should be anywhere between $17M-$25M. In fact, their latest SEC filing estimates this value at $15M-$25M. Although some years have been below average, over the last decade, owner earnings has grown from $12M to $48M (TTM), roughly 15% ann. Evaluating ROE & Cash Return on Invested Capital (CROIC) allows us to evaluate the ability of management to make money for its shareholders. It helps us answer the question: are they efficient allocators of capital? BBC over the last 10 years, had an average ROE of 14.7%, and currently trending upward. In 2009, ROE was 18%, and TTM ROE is 27%. CROIC tells us how efficient a business' operations and management can allocate capital into the business to create even more cash. In the short-term growth can happen at any rate. But over the long-term, a business will generally grow at the rate it can generate owner earnings. This growth depends on how much cash it generates based on total cash invested by shareholders and bondholders. In short, it can be viewed as the sustainable upper limit to a company's growth. CROIC has averaged 18% over the last decade, with the 2009 CROIC at 26% and TTM CROIC at 30%. BBC clearly generates cash and has the management acumen to generate a high ROE & CROIC. For every $100 invested, BBC generated $18 in owner earnings.

VALUATION Referring back to Buffett's comment on owner earnings in the previous section, owner earnings are the relevant item for valuation purposes and not accounting EPS. If I owned the business completely, the amount of cash that I could conceivably pull out of the business without hurting its competitive position or ability to maintain operations is what's of value (aka owner earnings). I focus on owner earnings and the likelihood of its growth over time based on the company's historical performance. The more consistent the company is, the closer my estimate of the future will be. These owner earnings cash flows are then discounted to the present to provide an intrinsic value, or fair value, to which I then apply a margin of safety. By comparing the owner earnings to the price paid for those earnings, I also examine the "owner earnings yield", which is a "bond" with a growing coupon over time, compared to the 10-yr Treasury. This provides an alternative view to assess how fairly priced an issue is. As Warren Buffett said before, "I would rather be approximately right, than precisely wrong." For a company that has a moat and/or which I deem to be a going concern, I use a simple two-stage DCF model; otherwise I'd value it as a liquidation. This model grows the initial owner earnings figure over 20 years. Years 1-3 use the initial growth rate. It is subsequently slowed down by 10% in years 4-7, and then slowed down again by another 10% in years 8-10. Finally, the terminal growth rate is applied to years 11-20. The basic DCF equation is: The initial owner earnings figure is $48M (TTM). Since BBC has consistently produced a CROIC of 18%+, I view CROIC as the most reliable indicator of their upper level performance. Since I may be wrong about their initial growth, I'll reduce this 25% just in case. This gives me an initial growth rate of 14% (which is also in-line with their book value growth). For the terminal rate, I apply 5%--a reasonable rate for a small and growing company. For a discount rate, I use the greater of: the 10-year T-bill, or 9%, which is based on: 3% for inflation; 3% for GDP growth; and 3% for corporate profits growth. For stable and consistent companies, I use a 25% margin of safety. For unstable or inconsistent operators, I'll use a higher margin of safety; if I invest in them at all…predictability is paramount. My conservative DCF analysis yields: fair value = $83. When viewed as Equity-Bond, the initial Owner Earnings yield = 3.9% growing at 14% (book value rate). It would take 5 years to double your owner earnings yield to 8%. By contrast, the 10-year T-bill yields a static 3.6%. Both measures illustrate there isn't much of a margin of safety at these prices yet.

DISCUSSION OF RISKS, COMPETITION, CATALYST, ETC.

RISK Boston Beer's portfolio is concentrated at the premium end of the craft beer industry, a category that has achieved strong growth in recent years. However, any change in consumer preferences for niche brands could hurt Boston Beer's revenue and affect their market share. Margins could be squeezed by rising commodity costs, and the firm is particularly exposed to fuel costs because it ships products from its manufacturing operations in the east of the U.S. to distributors in the west of the country.

COMPETITION BBC directly competes with other domestic craft brewers and imports for mind-share, and not necessarily the Big 3, although they've made their forays into the sector.

CATALYST I believe BBC will benefit from relative strength in the better beer category, and I see consumers continuing the longer-term trend of trading up, due to the demographic trend mentioned earlier in this analysis. While the recession caused some consumers to seek lower-priced alternatives over the near term, strong branding efforts are rejuvenating growth. Recent data confirms that their volumes are outperforming the overall beer category. BBC's financial flexibility, specifically that they have no debt, supports growth over the long term by enabling capacity expansion and additional marketing efforts. Although there's currently no mention of it, a brewery expansion project west of the Mississippi would help tremendously in penetrating the West easier and easing fuel costs. They could fund an expansion again in cash, easily paying for such a project out of 1 or 2 years' worth of owner earnings at the expense of a short-term hit to reported accounting EPS, such as in 2008. In October 2010, the board of directors approved an additional $35M increase to its existing $190M repurchase program. As of November 2010, BBC had approximately $37M remaining under the program. Lastly, BBC had only 6 analysts following it, compared to the 2 analysts when I first started studying the company in 2007. As they continue to grow, so will the analyst coverage.

SUMMARY I've attempted to provide a top-level review of the Boston Beer Company, producers of the Samuel Adams brand of beers. Of course do your own due diligence, but I'm sure you'll find them to meet all the business, management, and financial tenets that Warren Buffett would look for, provided he could invest in a company this small. They are a simple to understand, highly profitable, and value-creating business with a trustworthy and capable management team able to produce stable double-digit ROE, CROIC, and gross margins. They are the largest and most successful of the small craft brewers, have a growing moat, generate plenty of free cash flow, and have no debt. They currently trade at a small premium to fair value, which I estimate at $83. Buy under $62, with a margin of safety, and keep this one tucked away for the long haul since they have a long road ahead of them to grow.